Morgan Stanley Sees More Pain

Brokerage stocks drop a day after a huge Fed-fueled rally.
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The credit crunch that has hammered financial firms may take at least two more quarters to work itself out, Morgan Stanley (MS) - Get Report Managing Director Colm Kelleher said Wednesday.

The executive, who is expected to take over at year-end for retiring CFO David H. Sidwell, said during a late morning conference call that fears about the credit markets are likely to linger despite Tuesday's Federal Reserve interest-rate cut. But he is hoping that Morgan can scratch out opportunities anyway.

Kelleher's comments come a day after execs at Morgan's rival

Lehman Brothers

(LEH)

said they believe they have seen the worst of the credit crunch already. The comments are being weighed on Wall Street as investors await Thursday's updates from

Bear Stearns

(BSC)

and

Goldman Sachs

(GS) - Get Report

.

Crunched by credit worries and a writedown of assets on its books, Morgan Stanley posted a disappointing third quarter Wednesday. Earnings from continuing operations fell to $1.47 billion, or $1.38 a share, from the year-ago $1.59 billion, or $1.50 a share. Revenue rose 13% from a year ago to $8 billion. Analysts surveyed by Thomson Financial were looking for a $1.54-a-share profit on revenue of $8.35 billion.

The Wall Street firms' shares declined modestly Wednesday, after a sharp gain Tuesday driven by Lehman's optimism and the Fed's deeper-than-expected rate cut. Morgan fell $1.57 Wednesday to $66.94.

"Morgan Stanley's diversification across businesses and regions helped us deliver

return on equity of 17.2% this quarter, despite the impact of the severe market disruption on some areas of the firm -- including our credit products, leveraged lending and quantitative strategies businesses," said CEO John Mack in a written statement. "Even with these turbulent markets, Morgan Stanley still delivered strong performances across many core businesses and achieved record results in our prime brokerage, derivatives and interest rate & currencies businesses. In addition, we continued making progress in executing our growth plans and vastly improving performance in Asset Management and Global Wealth Management."

The news comes as investors scrutinize results on Wall Street to measure the impact of this summer's credit crunch. Big questions for the brokerage firms are how exposed they are to the meltdown of the mortgage-backed securities market and how much money they might lose on loans backing leveraged buyouts.

Morgan Stanley said third-quarter fixed-income sales and trading net revenues were $2.2 billion, a 3% decrease from the third quarter of 2006. The decrease was driven by significantly lower credit revenues as spread widening, lower liquidity and higher volatility resulted in lower origination, securitization and trading results across most products. Commodities revenues were down on lower trading results.

These decreases were partly offset by record results in interest rate and currency products, which benefited from stronger revenues in interest rates and foreign exchange. Fixed-income sales and trading also benefited by approximately $290 million from the widening of Morgan Stanley's credit spreads on certain long-term debt.

Other sales and trading net losses of $877 million primarily reflect losses of $940 million from marking to market loans and closed and pipeline commitments, largely related to acquisition financing provided to non-investment-grade companies.

Total leveraged loans in the pipeline were $31 billion at end of third quarter, execs said on the call, and accounted for $726 million of writedowns. Analyst Mike Mayo of Deutsche Bank estimates the firm took a 4% writedown on its leveraged-buyout loan books.

Staff reporter Laurie Kulikowski contributed to this report.